The S&P 500's 3 Most Hated Stocks

It hasn't exactly been smooth sailing for much of the technology or biotechnology sectors over the past two months, but that hasn't stopped the broad-based S&P 500 from flirting with a new all-time high.

Plenty of factors have been instrumental in pushing the S&P 500 ever higher over the years. Perhaps none has been more crucial than the Federal Reserve preserving historically low lending rates, allowing businesses to refinance existing debt and to take on additional debt in order to hire and expand at an attractive long-term cost.

Low lending rates have also worked in favor of the housing industry by allowing consumers to refinance their mortgage or take out a new mortgage at a reasonably low interest rate. The end result has been strong gross domestic product growth (polar vortex excluded), rising home prices, and a six-year low in the unemployment rate.

But no amount of good news in the world can keep the S&P 500s skeptics from popping out of the woodwork. Skeptics have a number of good reasons to believe the market is overvalued and could be headed lower. Primarily, they will focus on the fact that only about half of the S&P 500 companies up to this point have topped Wall Street's revenue estimates for the first quarter. Instead, companies have turned to share buybacks and cost-cutting to drive profits, which is simply unsustainable over the long run.

What's more, even though the unemployment rate has been dropping precipitously, nonfarm payrolls exclusive of the labor force participation rate are unchanged from May 2008. In other words, job growth has been nonexistent on a constant labor force participation basis.

Keeping these concerns in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's three most hated stocks. Why, you ask? Because this way we can better understand what characteristics, if any, attract short-sellers so that we can avoid buying similar companies in the future.

Here are the S&P 500's three most hated companies:

Company

Short Interest as a % of Outstanding Shares

GameStop

26.61%

U.S. Steel

22.96%

Joy Global

22.21%

Source: S&P Capital IQ.

GameStop Why are investors shorting GameStop?

There are two particular reasons why short-sellers have singled out video game and gaming accessories retailer GameStop as a company whose shares could head lower. First, GameStop is riding a "sales high" following the late 2013 releases of the PlayStation 4 and the Xbox One. With multiple years between gaming console releases, astute pessimists realize GameStop's same-store sales will be practically impossible to match in the upcoming quarters. Second, we're seeing a decisive push away from brick-and-mortar gaming retailers toward digital (PC and mobile) sales of games. As these digital sales pick up it's possible that GameStop's margins could erode.

Source: GameStop.

Is this short interest warranted?

While I appreciate GameStop's impressive cash flow, its ability to close underperforming locations to preserve that cash flow, and its general "cheapness" since it trades at just eight times forward earnings, I believe the threat from digital downloads is becoming quite real. Digital sales accounted for a paltry 1.8% of sales for GameStop in the fourth quarter and (get this!) actually fell from the same period in the prior year. Although used game margins and new hardware sales propped up GameStop in the interim, this doesn't look like a long-term solution for the gaming behemoth. Short-sellers just might be onto something here.

Source: U.S. Steel.

U.S. Steel Why are investors shorting U.S. Steel?

The pessimism surrounding steelmaker U.S. Steel is about as easy to understand as it gets: the company loses money. Despite reporting a first-quarter profit in April, U.S. Steel had previously produced five consecutive quarterly losses and hasn't delivered an annual profit in five years. A persistent oversupply of steel throughout most of the world shoulders much of the blame for U.S. Steel's poor results, in addition to weak prices as a direct result of that oversupply.

Is this short interest warranted?

It's clear that U.S. Steel is doing a very good job of controlling costs. Its latest quarter produced the first profit in more than a year despite 400,000 fewer tons of flat-rolled steel being sold. Yet, even though it is fairly inexpensive on a forward P/E basis (11), I'm not a huge fan of the company. To begin with, U.S. Steel is dealing with more than $2.8 billion in net debt which makes strategic maneuvers difficult. Also, steel producers in China are going to make it difficult for U.S. Steel to stay consistently profitable given their quicker access to faster-growing markets and the ability to flood the market with supply. Even with anti-dumping tariffs U.S. Steel's long-term potential isn't all that exciting, and I'd suggest investors leave this stock to the short-sellers.

Joy Global Why are investors shorting Joy Global?

Sticking within the commodities sector we have Joy Global, a heavy-duty manufacturing and mining equipment operator. Short-sellers have been piling into Joy Global with the expectation that weak commodity prices are going to discourage miners from boosting their production and ordering new equipment. Lack of equipment orders means Joy's backlog, as well as top-line and bottom-line results, will dip.

Is this short interest warranted?

Based on Joy's not-so-joyous first-quarter results announced in March, I'd certainly say that short-sellers have a case to be pessimistic over the near term. Joy Global's sales dipped 27% while bookings tumbled 16%. What's scary is that even with 2.3 million shares repurchased its earnings per share fell to $0.49 from $1.31 in the prior-year period. I see Joy's niche market position and ability to ramp up production as plenty of reason to believe it'll be successful over the long run, but over the next year or two it could indeed be rough sailing (or should I say digging?) for shareholders.

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